How Low Can Stocks Go?

Sure, stocks' rally over the past few weeks has been a fun ride, but how quickly we forget: Between Feb. 9 and March 9, the Dow Jones Industrial Average dropped by more than 1,700 points. Repeat another of those plunges, and the "Dow's going to zero" camp might start gaining attention again.

Of course, we're not going to zero. No matter how ugly the markets get, the ferocity of what we've been through over the past few months can't continue for long.

But here's the bad news: Just because zero is out of the question doesn't mean stocks won't plummet from here. In fact, they could fall much, much further.

And history agrees.

What goes up ...The history of long-term market downturns is hideous. When times are bad, markets don't just get drunk with fear -- they start downing vodka shots of it. When panic sets in, nobody wants to own stocks at any price. Investors' palms begin to sweat every time they watch CNBC. They bury their heads in the hope that the pain will go away. They throw in the towel and sell stocks indiscriminately. In short, things get really, really ugly.

Just how ugly? Have a look at the average price-to-earnings ratio of the entire S&P 500 index over these three periods of market mayhem:

Period

Average S&P 500 P/E Ratio

1977-1982

8.27

1947-1951

7.78

1940-1942

9.01

And while stocks have plummeted over the past year, so have corporate earnings: With a current average P/E ratio today of 25.57 (as calculated by Standard & Poor's) and a seven-year average of more than 24, it's pretty apparent that stocks could fall much, much further than they already have, just by returning to the lows they historically hover around during downturns.

Assuming earnings stay flat, revisiting those historically low levels could easily mean a 50% decline from here. For the Dow Jones Industrial Average, that could easily mean Dow 5,000, or worse. Now, I'm not predicting, warning, or forecasting -- I'm just taking a long look at history.

But what if it did happen?What would happen to individual stocks? Here's what a few popular names would look like trading at P/E ratios of 8:

But here's the silver lining: Every one of those stocks -- heck, the overwhelming majority of stocks -- are worth much more than a pitiful eight times earnings. The only thing that pushes the average stock to such embarrassing levels is an overdose of panic, rather than a good reading on what the company might actually be worth.

Be braveAs difficult as it is right now, following the "this too will pass" philosophy really does work. No matter how bad it gets, things will eventually recover. Those brave enough to dive in when no one else dares to touch stocks are the ones who end up scoring the multibagger returns.

Need proof? Think about the best times you could have bought stocks in the past: after the economy recovered from oil shocks in the '70s, after the magnificent market crash of 1987, after global financial markets seized up in 1998, and after the 9/11 attacks that shook markets to the core. As plainly obvious as it is in hindsight, the best buying opportunities come when investors are scared out of their wits and threaten to give up on markets altogether.

And that's exactly where we are today.

Pick what side you'd like to be onThe next few years are likely to be quite a ride. On the other hand, the history of the market shows that gloomy, volatile periods also provide once-in-a-lifetime opportunities that can earn ridiculous returns as rationality gets back on track.

If you need a few stock ideas, our team at Motley Fool Inside Value is sifting through the market rubble to find those opportunities. To see what they're recommending right now, click here to try the service free for 30 days. There's no obligation to subscribe.

This article was originally published on Oct. 18, 2008. It has been updated.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article.Pfizer and Starbucks are Motley Fool Inside Value recommendations. Starbucks, Apple, and Whole Foods are Stock Advisor selections. The Fool owns shares of Starbucks. The Motley Fool is investors writing for investors.

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I agree that panic is the primary reason for the dive. But the main reason for the panic is the know-it-all but know-nothing 'analysts' on Wall Street. Why anyone believes anything these guys say amazes me. I say we put them out of our misery.

Although the market needs a technical correction to the current rebound, we at Sabrient (quant equity research) have been stating that valuations are at extremely attractive levels. In our view, earnings reductions of many of the financials are one-time events, but many have been classified as recurring by current accounting standards. So, current P/E, measured apples-to-apples, reached more like 6-8x recently, which is the level many of the pundits say must be achieved before we have a true market bottom. Moreover, PPE (projected P/E, based on analyst consensus figures - even if you don't buy them) seems to have hit a historic low recently.

The average P/E ratios quoted in this article are based on reported earnings and so it follows that we must use reported earnings for current earnings and here are some reasonabl valuation levels over the next year or so with matching P/E ratios and S&P level:

$20 earnings x 10 P/E = S&P @ 200

$32 earnings x 15 P/E = S&P @ 480

$50 earnings x 20 P/E = S&P @ 1000

This is REAL data based on historical norms. Also consider that historical low points for P/E ratios are closer to 5 than 10.